Royce’s Nadel and His Bias for Predictable High-Quality Stocks

On the surface, singing the “I Love New York” jingle seems to have nothing to do with money management, but David Nadel learned a valuable lesson from doing this as a child. “I sang in the children’s chorus at the Metropolitan Opera [in New York] and on TV commercials,” the manager of Royce International Premier fund says. “I took after my dad, who wrote songs for Elvis Presley. The great thing about that line of work is that you have one upfront decision to do the performance [recording], and then you get these recurring payments for years from the residuals or royalties.”

Similarly, in his mutual fund (ticker: RIPNX), Nadel seeks companies with recurring revenues. “These are business structures where you have a front-end sale, but most of the money is made off spare parts or repairs, long-term contracts, or very-sticky customer relationships, things where you can have predictability,” Nadel says. This investment strategy, he notes, mirrors a private-equity one: “Late-stage private-equity investors are interested in reliable cash flows. Like them, we’re attracted to industries that are built to last and have a lot of pricing power and very strong customer relationships.” That means largely avoiding cyclical industries like energy, real estate, and banks, and favoring more-stable ones like health care.

The strategy works. Over the past five years, Royce International Premier has delivered an 8.7% annualized return, besting 95% of its peers in Morningstar’s Foreign Small/Mid Growth fund category. Since its December 2010 inception, the fund’s oldest share class—RYIPX—has produced a 7.2% annualized return, versus only 4.2% for the MSCI AC World Ex-USA Small Cap benchmark. More impressively, Nadel has done this with much less downside risk. The fund has captured 100% of the upside on positive days for international stocks, while suffering only two-thirds of the benchmark’s losses on down days, according to Morningstar. This is a testament to the resiliency and high quality of the businesses he invests in.

Nadel particularly likes companies in the business-to-business part of the industrial sector—36% of his portfolio—as he says that corporate customers are more loyal than individuals. One example is IMCD (IMCD. Netherlands), a Dutch marketer and distributor of specialty chemicals such as food flavorings and fragrances. The company has exclusive relationships with its suppliers, and 43,000 customers worldwide. “They don’t face competition in their supplier relationships, and those last an average of 10 years,” Nadel says. Specialty chemical suppliers stick with IMCD because of its expertise, and customers often can’t purchase the unique flavors and scents anywhere else.

Nadel’s style is somewhat of an anomaly at Royce Funds, which historically has specialized in U.S. small-cap value investing—buying cheap, often beaten-up stocks. Nadel will pay up for quality. “We want the competitive positioning of the company to be favorable, so the business typically is the global No. 1 at what they do,” he says. Such market leaders don’t generally come cheap.

One concern with this fund is key-man risk. Nadel and his co-manager, Mark Rayner, run the portfolio largely by themselves. Rayner, a British accountant by training, joined Royce as a Western European small-cap analyst shortly after Nadel’s 2006 arrival. “Royce had no specialist like that before Mark came,” Nadel says. The two worked on the Royce Global Select Long/Short fund, with Nadel acting as manager of it from 2006.

Nadel brought Rayner on board at Royce International Premier about four years after Royce launched the fund in 2010. “We both take a generalist approach,” he says. “We do call on an analyst pool for some support but not much in the way of idea generation. The key is the investment process because if you have a well-defined process and you identify and stay within the boundaries of that process, then you don’t really need a large analytical team.”

That process begins with a screen of foreign stocks for metrics of high-quality companies, such as high returns on invested capital and low debt. For the companies that remain, Nadel applies an enterprise quality scoring system that he and Rayner developed based on research by Michael Porter, the well-known professor at Harvard Business School, where Nadel got his M.B.A. They score the companies from 0 to 100 in five key areas—the appeal of the sector, industry leadership, operational efficiency, financial performance, and corporate governance.

Then, and only then, does Nadel consider valuation. “A lot of value investors fall into traps because they screen for things that are cheap, and they wind up with something that they have to continually justify,” he says.

Nadel’s high-quality bias doesn’t just apply to stocks and sectors but to countries, as well. “The bulk of our holdings are from markets where shareholders rights and corporate ethics are at or better than U.S. levels,” he says. So, he invests more in developed stalwarts like Switzerland, 11% of his portfolio, and Australia, 9%, than in riskier emerging markets like India, 2%, or China, 2%.

One Australian holding is Cochlear (COH. Australia), which invented the cochlear implant that helps deaf people hear. “They have about a 70% global market share on cochlear implants,” Nadel says. “The typical beneficiary of a cochlear implant is a child, so you can expect that child to live 70 or 80 years. Well, about 30% of this company’s operating income comes from aftermarket service such as software updates. So, you can do a 70-plus year discounted cash-flow [model] per patient. It is an incredibly predictable business.”